Bad Investments

The first thing to know about investing your hard-earned money is how to avoid bad investment advice.

Fortunately, there is a simple principle that you can use to cut through 99.999% of it.

There Are No Oracles

Or, to be precise, there is one Oracle, and it makes database software and draconian licensing agreements.

There are no market oracles.

By “oracle” here I mean an information source that can tell you for sure about the future movement of a market price.

Non-Existence Proof

The concept of an oracle seems clear enough, so we can ask: what happen if an oracle exists?

Suppose I have an oracle and it tells me “FOOBAR will go up by 1% next week”.

I have $1000 to invest, so I use the tip. How much money do I make?

> FOOBAR will go up by 1% next week, and I have $1000 to invest; how much money will I make?

If you said "$10”, great! You are reading exactly the right post, because you are about to learn something.

For a start, you absolutely would not buy FOOBAR. What you would want is called a “call option” on FOOBAR. A call option is a contract that gives you the power to buy FOOBAR for a specified price at a specified date in the future.

Each call option that you will buy says “In a week’s time I can buy one FOOBAR for today’s price if I so choose”, and you buy as many such call options as you can afford. Each is much cheaper than FOOBAR itself, because its possible actual value in a week’s time ranges from zero—if FOOBAR should go down—to some small dollar amount corresponding to the week’s price increase.

When you cash in—“exercise”—a call option you don’t actually have to supply the money to buy a FOOBAR, they just pay out the difference if it’s positive.

You might lose the whole $1000 if you are wrong. But you have an oracle, so you know you’re not wrong. It’s a safe bet—and now it gives much more than 1% profit.

By increasing the downside of the bet, you’ve also increased the upside.

And we’re not done. We’ve managed to risk losing the whole $1000, and be rewarded for that risk—but we can go much further.

The next step is to bet more money than you have. This might be surprising—but it’s common practice. It’s called leveraged investing.

So you use the $1000 to secure a loan for $5000, then spend the whole loan on options. This, I must be clear, is a terrible idea—unless you have an oracle. Because you have an oracle, you’re safe: you’ve increased the downside if you lose, to $5000, but you don’t care; you are guaranteed to pocket the upside.

That upside is going to be a lot more than 1%; for the sake of argument let’s say you double your money, to $1000.

You have an oracle, so the next week you get another tip and do the same, but this time investing twice as much.

And you do the same every week for ... actually, not that long, because after 36 weeks of doubling your investment you possess 68 trillion dollars, which is most of the money in the world.

QED

We turned our oracle about a stock price going up 1% into all the money in the world in less than a year.

This might seem fanciful, and it is—but not the part about the exponential growth of the money. That’s what happens if you find a way to break the system. The only unrealistic part is that it would certainly be noticed and stopped well before week 36.

“Noticed” is key. We do notice financial scandals that break the system to achieve impossible growth—like Enron did. They didn’t have an oracle; they cheated.

If there were any oracles, we would notice. We don’t.

Therefore, there are no oracles.

Types of Bad Investment Advice

There are two common types of false oracle.

One is free, and the output of this type of false oracle is plastered all over the web and TV. Someone who looks respectable confidently predicts that company X is doing Y and so the stock price will do Z; or must do Z soon; or will do A, B or C for sure. This type of “prediction” is exactly the same business as horoscopes. It drives ad views and reach, nothing more. It’s noise.

The second is not free: it happens when you hand over your money in exchange for access to an implied-but-not-promised oracle. This happens with “active funds” that charge a yearly “management fee”; with hedge funds; and with any market “tips” that you pay for in any way.

Both of these can be argued against with a simpler argument than the reasoning above. Free advice can’t be worth anything—or it would not be free. Paid advice does not make sense—if someone has an oracle they can borrow money to invest but then keep all the profit, returning just the pre-agreed fixed interest to their creditors.

Summarized

> Do not trust market tips given for free; they are free because they are worthless.

> Do not trust market tips sold for money; if they were real, they would be used, not sold.

> Do not trust someone who invests your money while charging a nontrivial fee; if they had a winning way to invest, they would keep the risk and profit, not give it back to you.

Good Investment Advice

So, what’s left? Where is the good advice?

There is very little. It could, for example, easily fit on some random Gemlog that you just happened to stumble upon.

Stay tuned.

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